Fund flows show investors favoring bonds over stocks

Weekly flows into global mutual funds indicate that investors are maintaining a bullish bias for bonds and gold, while still scouring stocks—seen by some as pricey—for bargain opportunities, according to Bank of America Merrill Lynch research.

Over the past week, investors poured $6.6 billion into bonds funds and $3.7 billion into stocks. Gold funds attracted $1.3 billion, the biggest weekly inflow for the metal in 30 weeks, according to BAML.

BAML analysts said investors rushed into U.S. and Japanese equities on Tuesday when the S&P 500 index SPX, -0.15% fell 0.8% on fears over North Korea and Hurricane Irma, with equity inflows of $5.1 billion.

Overall, investors have gravitated to foreign equities over their domestic counterparts. Last week, marked the 11th out of the past 12 weeks of net outflows for U.S. equities. Specifically, investors turning abroad poured money into emerging markets, European and Japanese equity funds.

In bond markets, investment-grade paper kept up a hot streak, with inflows for the 37th straight week. Last week’s inflow was $2.2 billion. Investors poured $1.7 billion into emerging-market debt. That represents the 32nd weekly positive flow in 33 weeks. Last week, investors bought $1.8 billion worth of government bonds—the largest amount in 61 weeks.

Read: Long-dated Treasury ETF sees largest inflows since May 2011

The second straight week of moderate high-yield fund flows—at $0.8 billion—suggest that investors continue to hunt for richer yield in an environment where rock-bottom yields are still prevalent.

U.S. equities finished the week with modest losses, with the S&P 500 SPX, -0.15% closing at 2,461, but the benchmark is still trading near its all-time high set last month, as investor appetite for risk is supported by those low yields in bonds.

10-year Treasury yields TMUBMUSD10Y, +0.76% have fallen to 2.06%, the lowest level since Nov. 9, the day after the U.S. Presidential election.

Historically low interest rates and stocks at near record levels have raised eyebrows among market participants. Bond prices, which move inversely to yields, rise at times of stress, with investors fleeing risky assets such as equities.

However, BAML analysts see no disconnect between bonds and stocks.

“The best explanation for low yields and high stock [prices] is $1.96 [trillion] of central bank purchases of financial assets in 2017 alone (central bank balance sheets up $11.26tn since Lehman [Brothers] to $15.6tn),” they wrote.

“Second best [explanation] is bonds are pricing in low inflation (increasingly a new structurally low level of inflation due to tech disruption of labor force) while equities are pricing in high earnings growth (with little on horizon to meaningfully reverse trend).” Inflation has tended to hang below most central bankers’s roughly 2% target, seen as indicative of a healthy economy.

BAML analysts said stocks have a history of good returns in times of falling inflation.

However, there are scenarios under which bond yields could pose a threat to rising equities, according to BAML. The so-called inverted yield curve, where short-term yields are higher than their longer-tenured counterparts, could be one such scenario. Such a market dynamic in Treasury yields has tended to be a precursor to economic recessions. Also rising yields that coincide with falling stocks of banks and home builders, may signal economic contraction, the analysts said.

So far, the Federal Reserve’s slow and gradual approach to rate increases is unlikely to invert the yield curve just yet and healthy credit spreads suggest that consensus, once again, is discounting a more protracted period of anemic economic growth and ultralow yields.